Closing the Deal: How Taxes Impact a Transaction– February 25, 2016by Mike Kolk

Since 2008 there has been a significant increase in M&A activity. Buyers, both strategic and private equity firms, are more actively coming to the table. If key tax concerns are addressed prior to the negotiation process, they often can help bridge the gap between what the sellers want and what the buyers are willing to pay.

Below is Tax Partner Mike Kolk’s interview with Taxonomicsmagazine to break down the essential tax issues and opportunities of a successful transaction.

Taxonomics: As a seasoned M&A tax professional, what trends are you noticing in the market?

Kolk: In the last three to five years, more deals have involved private equity firms. These sophisticated buyers and sellers are tax savvy and know how to structure the deals to their best financial advantage.

As a result, large multiples are being paid and some deals are taking on unique structures. The smaller buyers are still out there, but it is much tougher for them to contend, so they have to be more flexible on how they structure a deal. That flexibility, however, may result in a more advantageous after-tax result for the seller than an offer with a higher headline price.

Another trend is that sellers are taking a more holistic approach to the deal. Often, their personal financial situation is integrated with the business so the two must be addressed simultaneously. It’s not uncommon for our clients who are selling their businesses to work with our related entity, Sequoia Financial Group, or another qualified financial planner to develop a financial model that examines how much money will be needed to live comfortably in retirement based on their unique situation and desires. Then we work on the tax side of the business sale to structure the deal to meet, if not exceed, the seller’s personal financial goals.

Taxonomics: What are the primary deal structures to know in any M&A transaction?

Kolk: It’s typically either an asset sale or a stock sale. Buyers tend to want to buy assets; sellers often want to sell stock.

To determine the deal structure, you first must identify any business or legal issues that could affect the deal’s framework. For example, consider a seller who has a contract with a large customer that stipulates it cannot be assigned to a successor. In an asset sale, the new buyer may not have the rights to fulfill that contract without time-consuming negotiations. In a stock sale, the company would be the same legal entity and the customer contract could continue.

Generally speaking, sellers fare better if they can sell ownership units (shares) because they have only one level of taxation at the lower capital gains rate. Buyers prefer asset sales because they can step up depreciable cost basis, but sellers can get hit with two levels of taxes — at the corporate and shareholder levels. We work with clients to modify the form of the sale to get better tax results, creating a win-win scenario for the buyers and the sellers.

Taxonomics: What payment structure options are available?

Kolk: A key element for sellers often is how the payment terms will impact the timing of taxes. If they defer payment and carry a note from the buyer, they receive interest on the entire purchase price and the tax impact is dispersed over the term of the note. However, with longer terms, the sellers must be confident in the buyer’s ability to operate the business.

Equity-roll over structures are more popular today because many sellers are younger and aren’t ready to get out of the business entirely. However, they don’t want to keep all their financial worth tied up in the business either. In these situations, a seller retains a portion of the business even after the sale. The right deal structure is important to avoid double taxation when the retained percentage is eventually sold. In some cases, it may make sense to create a clean separation and do a deal where 100 percent of the business is sold in an asset sale, and the seller reinvests in equity in the buyer’s new entity.

Another option is a deferred compensation deal. These are sometimes tied to an earn-out — the additional amount a buyer would be paid based on future performance of the business. While it could be structured as an additional purchase price, the buyer benefits more if the payment is structured as deferred compensation because the buyer is then eligible for a tax deduction.

Taxonomics: What is the tax impact of the sale (asset or stock)?

Kolk: It comes down to how the purchase price is allocated. Buyers and sellers usually have opposing preferences. If it is a capital-gains sale for the seller, the buyer typically cannot amortize the cost any quicker than over 15 years, if at all. If the sale triggers ordinary income tax to the seller, the buyer typically receives an immediate write-off or short-term depreciation deduction. There is a lot of gamesmanship in purchase price allocations.

Taxonomics: What other tax issues can come into play?

Kolk: State tax nexus is certainly one of them. Identifying the recognized locations of the business is critical, especially since more states and local jurisdictions are looking for additional funds to help support their shrinking budgets.

Sometimes a seller has nexus in a given state but hasn’t filed properly. While the seller may be comfortable taking that risk, those tax obligations will be transferred to the buyer on the close of the sale. It is a significant area to address in the due diligence process.

Other factors to address in closing a deal could fill a two-volume treatise and will always be somewhat deal specific. The thing to remember is that the right tax strategies can play a huge part in helping to close the deal — whether producing tax savings to improve net proceeds for the seller, or effectively reducing the purchase price and/or risk for the buyer. Both sides stand to benefit from a well-planned, tax-efficient sale.

We want to hear from you! We encourage you to comment below on this blog post, share it on social media or contact Mike Kolk at mkolk@cohencpa.com or a member of your service team for further discussion.